Cover Story

Not So Radical Reform

"I have nothing to say except I know how Britney Spears feels," said Representative Barney Frank on Sept. 27, 2008, after yet another day in which a pack of journalists followed his every move. In the frenzied early reckoning of the financial crisis, Frank, the 15-term Massachusetts Democrat known for being the second openly gay member of Congress—and the first member for reporters to hit up for a great quote—made the rare Washington leap from colorful supporting player to full-fledged protagonist: As the chairman of the House Financial Services Committee, the banking industry was a sick patient at his feet. Main Street demanded change. Wall Street feared it was coming. And Frank promised to deliver. "You need a new tool kit for new phenomena, and our job next year is to develop that toolkit," he said in an interview with Bloomberg News.

Frank's legislative agenda was ambitious. He pushed for the creation of a council of regulators to oversee systemic risk; the establishment of a national consumer protection agency; stricter standards for hedge funds, private equity firms, and credit-rating agencies.

The federal government certainly went to extraordinary lengths to forestall a depression and to save the banking system. Congress passed the $700 billion Troubled Asset Relief Program in 2008. Fannie Mae and Freddie Mac, the giant government-sponsored enterprises that are the backbone of America's housing industry, were essentially nationalized. The U.S. Federal Reserve and the Treasury presided over the restructuring of Wall Street, including the bankruptcy of Lehman Brothers, the sale of Bear Stearns, and the conversion of Morgan Stanley and Goldman Sachs into bank holding companies. Meanwhile the government, during the worst of the panic, seemed to roll out a new relief program every week, including a rescue package of American International Group. (Subsequently it has forced the brief bankruptcies of General Motors and Chrysler.) Some of these measures carried short-term stipulations such as compensation limits that the financial institutions, and the well-paid executives who run them, don't like.

But rescuing the system is hardly the same thing as reforming it, and a diverse chorus of voices worries that, with the stock market's recovery and the last of the big banks poised to leave TARP, the moment for real change has been squandered. It's not only a concern in the U.S.: In Europe regulators and policymakers so far haven't enacted a single proposal that would overhaul the financial system. "Meaningful regulatory change is urgent now because this is the window of opportunity," warns Simon Johnson, a professor of entrepreneurship at Massachusetts Institute of Technology and a former International Monetary Fund economist. "If that window closes, we're asking for trouble." Paul Volcker, chairman of President Barack Obama's Economic Recovery Advisory Board and former chairman of the Federal Reserve, recently visited nine cities in five countries delivering speeches warning that bankers and regulators around the world "have not come anywhere close to responding with necessary vigor." Volcker wants lawmakers to bust up the big banks. Since the crisis began, the institutions deemed "too big to fail" have only gotten bigger; at the end of 2008 the world's 10 largest banks had 26% of the assets of the top 1,500 banks, up from 18% in 1999.

So what happened to Frank's initial fervor? The stock market recovery-the Standard & Poor's 500-stock index is up 67% since the March 2009 low-drained some anger from the debate, and after months of haggling over health care, legislators heard from their constituents that regulation was no longer a word with magic healing powers.

More important, Frank, House Speaker Nancy Pelosi, and other left-leaning Democrats have had to deal with the New Democrat Coalition, a moderate group inside the party that shares many of the values associated with Bill Clinton and the Democratic Leadership Council, which was founded 25 years ago in the belief that Democrats couldn't win elections without a strong moderate platform.

In the House of Representatives, where the debate on regulatory reform started, the New Democrat Coalition has 68 fiscally conservative, pro-business members who fill 15 of the party's 42 seats on the House Financial Services Committee. And with just a 38-member voting majority over Republicans (who often vote as a block in the House), Frank and Pelosi can't push legislation through without the New Democrats' support. "We're pro-growth, innovative Democrats with real-life experience," said New York Representative Joseph Crowley, the Coalition's chairman. "Many of us come out of the business world." The group's growing importance isn't lost on the President. After traveling to Manhattan in September to rally support for financial regulation, Obama invited a couple of members, including Crowley, to fly back with him to Washington on Air Force One.

The New Democrats' ties to Wall Street are strong. Jim Himes, a first-term congressman from Connecticut, is a former Goldman Sachs (GS) investment banker. Representative Mike McMahon represents a large constituency of Wall Street employees in Staten Island and Brooklyn. Crowley likes to point out that workers in his Bronx and Queens district sweep the floors, drive the cars, and pull the beer taps for Wall Street traders. Since the start of the 2008 election cycle, the financial industry has donated $24.9 million to members of the New Democrats, some 14% of the total funds the lawmakers have collected, according to the Center for Responsive Politics. Representative Melissa Bean of Illinois, who has led the Coalition's efforts on regulatory reform, was the top beneficiary, with donations of $1.4 million.

While the House Financial Services Committee was tweaking the reform bill proposed by the Obama Administration this summer, the New Democrats pushed back on key regulatory issues. One of the biggest: derivatives, the complex financial instruments that helped spark the global financial crisis. Most derivatives are traded in murky over-the-counter deals. The Administration wanted to push some of them onto regulated trading platforms. But that would have crimped one of Wall Street's most lucrative businesses: The top five U.S. commercial banks, including JPMorgan Chase, Goldman Sachs, and Bank of America, were on track through the second quarter to earn more than $35 billion in 2009 trading unregulated derivative contracts, according to a review of company filings with the Federal Reserve and people familiar with the banks' income sources. So JPMorgan, along with Goldman Sachs and Credit Suisse (CS), lobbied McMahon, Bean, and other New Democrats to temper the proposed rules.

The New Democrats in turn reached out to Frank. As Obama vowed in the Sept. 14 speech in New York's Federal Hall to correct "reckless behavior" on Wall Street, McMahon and Frank sat together in the audience and discussed the Administration's proposed rules. The freshman congressman told Frank he was worried that Obama's derivatives plan would penalize a wide swath of U.S. corporations, not just banks, and would push jobs overseas. McMahon said Frank agreed it was important to protect so-called end-users, the corporations that rely on derivatives to hedge against fluctuations in foreign currencies, interest rates, and commodity prices. "He said we'd be working together on this," McMahon told Bloomberg News. "We never had a philosophical difference."

Two weeks later, a half-dozen New Democrats pressed Treasury Secretary Timothy Geithner to exempt end-users from the rules. "We were in the weeds on the derivatives bill," said Himes of the meeting, which was also attended by Bean, Crowley, and McMahon. Meanwhile, business trade organizations were rallying around the derivatives issue. In August three large trade organizations—the National Association of Manufacturers, the U.S. Chamber of Commerce, and the Business Roundtable—formed the Coalition for Derivatives End Users. The 171-member group, which includes MillerCoors, IBM (IBM), Apple (AAPL), and Johnson & Johnson (and no financial companies), sent a letter to Congress on Oct. 2 saying some reform proposals "place an extraordinary burden on end-users of derivatives."

The pro-regulation forces backed down. Under the House bill that passed in December, banks won't have to trade standardized derivatives on regulated trading platforms, although they will have to report the deals to regulators. And airlines, energy companies, hedge funds, and other end-users are exempted from many of the rules. "There are some things in there that are irritating to the Street," says Chris Whalen, managing director of Institutional Risk Analytics, a research firm in Torrance, Calif. "But compared with what we thought we were going to get over the summer, it's night and day." In an interview with Bloomberg TV on Dec. 11, Frank called the end-user exemption a "small dent" in his bill. "If you take the total number of derivatives done by Caterpillar, Boeing, John Deere, Cargill, and a number of other manufacturers, you're not going to create a systematic problem," says Steven Adamske, a spokesman for the House Financial Services Committee.

At the last minute Bean and her fellow New Democrats also delayed debate on the House reform bill to negotiate more changes. The proposed legislation to create a Consumer Financial Protection Agency allowed states to apply tougher rules to safeguard consumers; national banks sought to block the measure. On Dec. 7, Bean proposed an amendment to give federal regulators more discretion to override state consumer protection laws than what was initially proposed. Lawmakers held discussions on Dec. 9, the day of the debate, on whether or not to include Bean's provisions. In the early evening, House Majority Leader Steny Hoyer shuttled between Frank and other top lawmakers in one office and Bean and Treasury officials in another. After an hour, Frank emerged and told reporters that a version of Bean's proposal would be in the final bill. "Some of the banks had a successful run at lobbying the New Dems," Frank said in a Dec. 10 interview. Bean says she isn't carrying water for Wall Street, pointing to her support for the Consumer Financial Protection Agency that the industry didn't like. "I think we differ," she says.

The New Democrats' fingerprints are all over the final House bill. Lawmakers rejected a mortgage "cram-down" amendment, which would have given federal judges the power to extend loan terms, lower interest rates, and cut principal for bankrupt homeowners. Although lawmakers ultimately voted to create a consumer protection agency, the New Democrats succeeded in stripping the proposal of some components. Under the bill, real estate agents, auto dealers, and other nonfinancial companies won't fall under the purview of the agency. And the largest banks won't have to offer plain-vanilla credit-card and mortgage products.

While the House came to a consensus that deemphasized some reforms, the Senate still can't agree. Senators Christopher Dodd (D-Conn.) and Richard Shelby (Ala.), the ranking Republican on the Senate Banking Committee, tried for months to hammer out a bill, but Shelby balked at some of the components. Unable to find a compromise, Dodd decided in November to offer up his own proposal without Republican support.

Almost immediately Republicans began to trash the legislation. With discussions at a standstill in November, Dodd opted for a fresh approach. The Banking Committee formed four teams of committee members—with one Republican and one Democrat on each team—to work out a bipartisan compromise bill. They're hashing out everything from new rules for the credit rating agencies to possible limits on executive compensation. "These talks have been extremely productive with members providing great insight," Dodd and Shelby said in a Dec. 23 press release. A bill might not be ready until the spring, according to Shelby. "Wall Street is probably happy with the slowness of the process," says Paul Miller, an analyst with investment bank FBR (FBCM) Capital Markets, "because the slower the process, the more you can drag it out and water it down."

Meanwhile, the onslaught from the financial services industry continues. The U.S. Chamber of Commerce has focused on the Consumer Financial Protection Agency, a possible component of the bill that Dodd is trying to craft. The lobbying group launched a television advertising campaign titled "No Sleep" to illustrate the sleepless nights of business owners overwhelmed by regulation, and created a Web site to stoke opposition. The campaign follows a grassroots effort in August to block the formation of the agency; back then bankers visited lawmakers in 36 states and wrote more than 75,000 letters to Congress, according to David Hirschmann, head of the Center for Capital Markets Competitiveness, a Chamber-led initiative focused on financial regulation.

It's possible public anger could yet fuel a regulatory push. Banks will start giving bonuses to their employees in January; the bigger the payouts, the bigger the potential outrage. Senators John McCain (R-Ariz.) and Maria Cantwell (D-Wash.) on Dec. 16 proposed a bill that would reinstate the 1933 Glass-Steagall Act, which separated commercial banking from investment banking until its partial repeal in 1999. "Wall Street firms have recovered nicely and profits are soaring," McCain said in a press conference, while "Main Street is suffering terribly." The same day Representative Maurice Hinchey (D-N.Y.) put forth similar legislation in the House. But even he thinks it's a long shot: "There's a lot of pressure coming from the big banks to prevent this kind of thing from happening."

A failure wouldn't surprise frustrated lawmakers disappointed by the turn in Washington. "My greatest fear for the last year has been an economic collapse," says Representative Brad Miller (D-N.C), who sits on Frank's House Financial Services Committee. "My second greatest fear was that the economy would stabilize and the financial industry would have the clout to defeat the fundamental reforms that our nation desperately needs. My greatest fear seems less likely...but my second greatest fear seems more likely every day."

With Gadi Dechter and Robert Schmidt in Washington and Michael J. Moore in New York